Review of Financial Studies Vol. 22 No. 11 2009
A Dynamic Model of the Limit Order Book
Abstract
I propose a continuous-time model of price formation in a market where trading is conducted according to a limit-order book. Strategic liquidity traders arrive randomly in the market and dynamically choose between limit and market orders, trading off execution price with waiting costs. I prove the existence of a Markov equilibrium in which the bid and ask prices depend only on the numbers of buy and sell orders in the book, and which can be characterized in closed-form in several cases of interest. My model generates empirically verified implications for the shape of the limit-order book and the dynamics of prices and trades. In particular, I show that buy and sell orders can cluster away from the bid-ask spread, thus generating a hump-shaped limit-order book. Also, following a market buy order, both the ask and bid prices increase, with the ask increasing more than the bid—hence the spread widens.
- DOI
- 10.1093/rfs/hhp011
- Volume
- 22
- Issue
- 11
- Pages
- 4601-4641
- Language
- en
- Sources
- openalex crossref